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Can IBM Afford to Raise Its Dividend?

IBM has a history of dividend increases, but could the company's current troubles derail a dividend increase this year?

Like clockwork, International Business Machines(NYSE:IBM) has increased its dividend every single year for the past nineteen years, and the company has been paying dividends to shareholders for nearly a century. The last dividend increase, announced in April of 2014, hiked the quarterly dividend by 16%, the eleventh double-digit increase in a row.

But with all the trouble that IBM has had over the past year, from declining revenue to abandoning its 2015 earnings target, can IBM still afford to be so generous with its dividend? Will this year mark the end of IBM's 19-year streak of dividend increases? Or can the company continue to boost the dividend despite the challenges that it's currently facing?

IBM's dividend isn't actually that highOver the past decade, IBM's dividend yield has never been very high, excluding the period during the financial crisis when the stock price was depressed. Only recently, as the stock price has declined, has the dividend yield approached that of other big technology companies. Currently, IBM yields about 2.7%, similar to the dividend yields of Microsoft and Cisco.

IBM has favored share buybacks over dividends, spending far more buying back its own shares over the past five years than on dividend payments. While the dividend has been growing at a double-digit rate for the past decade, the payout ratio has remained quite low. In 2014, IBM reported EPS from continuing operations of $15.59, with an annualized dividend payment of $4.40 based on the current quarterly dividend. This puts the payout ratio at just 28%, or 35% of free cash flow.

Regardless of what number you consider, IBM has plenty of room to grow the dividend. Many of IBM's peers pay out a larger percentage of earnings: Microsoft had a payout ratio of 40.7% in fiscal 2014, and Cisco had a payout ratio of 48.4%. Even if earnings stagnate, it would take five years of 10% dividend increases for IBM's payout ratio based on net income to reach 45%, excluding the effects of further share buybacks.

This picture changes if IBM's earnings decline, but the low payout ratio gives the dividend a significant buffer against that possibility. Earnings could fall by 50% and IBM would still have no trouble paying its dividend.

A shift toward dividendsIBM can certainly afford to increase the dividend further, and I suspect investors will see another double-digit increase in April. In the long-term, it appears that IBM is shifting its strategy away from enormous share buybacks and toward a higher dividend. Over the past five years, IBM spent a staggering $70 billion on share buybacks, reducing the share count by more than 25%.

IBM's long-term financial model, laid out in its recent investor briefing, calls for share count reductions of just 2-3% annually, along with returning 75-85% of the free cash flow to shareholders. Based on the free cash flow from 2014, IBM expects to return between $9.3 billion and $10.5 billion to shareholders annually. A 2-3% share count reduction based on the current market capitalization would cost IBM between $3.25 billion and $4.85 billion. If IBM buys back 2.5% of its outstanding shares annually and returns 80% of its free cash flow to shareholders, for example, it would have $5.85 billion left for dividends.

In 2014, IBM paid out just $4.27 billion in dividends. Depending on the buyback activity and the percentage of the free cash flow returned to shareholders, IBM could be planning to accelerate its dividend growth. At the very least, it appears that the plan is to maintain the double-digit dividend increases of the past decade going forward.

Despite the turmoil that seems to define IBM these days, there's no real risk that the company is going to stop increasing its dividend. In fact, dividend growth could accelerate as IBM slows down its share buyback activity. Investors should expect a hearty dividend hike this April from IBM.